Futures contracts and options on futures contracts can be distributed or executed through a variety of means. Historically, futures were largely executed or transacted on the floor of an exchange in so-called “trading pits” that facilitated physical interaction between floor brokers and floor traders. This method is commonly known as “open outcry.” Although some open outcry trading still occurs, most futures contracts and options are now transacted through electronic trading systems. One example of such a system is the Chicago Mercantile Exchange GLOBEX electronic trading platform. The GLOBEX system and other electronic trading systems allow customers (e.g., parties wishing to transact in futures contracts and/or options) to establish an electronic link to an electronic matching engine of a futures exchange. That engine, which may be a computer system or a part of a larger computer system, identifies orders that match in terms of commodity, quantity and price.
Submission and processing of customer orders for exchange-traded futures and/or options are facilitated by a variety of entities known as “channel partners” of the exchange. Channel partners can include futures brokers, clearing members (CMs) and independent software vendors (ISVs). Customers, including retail and institutional traders, will typically open or establish futures accounts with futures brokers. In the United States, such brokers are also known as “futures commission merchants” (FCMs). FCMS are licensed by governmental authorities to solicit and accept customer orders for entry into exchange market mechanisms. FCMs may further establish relationships with exchange CMs to facilitate the financial standing of a transaction. In particular, only CMs interact directly with an exchange clearing house. The exchange clearing house stands as buyer to every seller and seller to every buyer, for purposes of attaching certain financial safeguards to each transaction. A CM essentially guarantees the financial integrity of an FCM's transactions, and thus the integrity of customer transactions through that FCM, to the clearing house. In many cases, an FCM may also be a CM, or the FCM and CM may be related corporate entities.
Although FCMs and CMs may act as financial intermediaries between the exchange clearing house and the customer, an FCM need not actually handle orders as a customer places those orders electronically. Many exchanges, including CME Group, adhere to a direct access policy such that customers may enter their orders directly into the exchange matching engine. So that a customer can obtain that direct access, however, the FCM and CM may effectively sponsor the customer by financially guaranteeing customer trading activity to the exchange clearing house. Moreover, a customer order destined for the exchange electronic trading platform may be initially received by an electronic platform operated by the FCM. The electronic platform operated by the FCM (or another platform operated by a CM associated with the FCM) may then transmit the customer order to the matching engine of an exchange (or to matching engines of multiple exchanges). In some cases, an electronic platform operated by an FCM or CM is a proprietary routing system developed by the FCM or CM. However, many FCMS and CMs utilize services of ISVs. Those ISVs provide routing systems on a fee basis, usually featuring functionalities designed to facilitate trading activity. In many cases, an FCM and/or a CM will insert credit controls into a routing system to limit customer activities within certain defined parameters as a risk containment measure. For example, an FCM might configure its platform to allow a customer to directly communicate orders to the exchange via the FCM platform as long as various conditions (e.g., a valid account, sufficient margin, etc.) are satisfied.
After an electronic matching engine or other trading platform of an exchange matches a customer order received via an FCM, the executed order (or “fill”) is reported back to the customer. The transaction may further be reported to the exchange clearing house. The clearing house generates bookkeeping reports that are transmitted to the CM and/or FCM representing the customer. The FCM or CM may provide the customer with periodic financial reports regarding the customer's account activity.
The underlying subject of a futures contract is sometimes referred to as the “spot” or the “cash” commodity or instrument. Examples of such subject matters include, without limitation, commodities (e.g., agricultural commodities, energy commodities, metals), foreign currencies, debt obligations, and securities. In addition to a market for futures contracts and futures contract options provided by an exchange, there may also be a “spot market” for subject matter that underlies futures contracts and futures contract options. In a spot market, a commodity, currency, debt obligation, security or other subject matter is bought and sold for cash and delivered immediately. By contrast, a futures contract is an agreement to deliver a particular subject matter (or its cash value) on some future date for an agreed price.
Futures tend to be very liquid. In many cases, a market for futures in an underlying spot may be more liquid that the spot market. Because of this, economic information can be conveyed by a futures price. Indeed, spot transactions are sometimes priced by reference to futures activity. And while futures may generally be quite liquid, there remain many customers who might prefer to trade in a spot market rather than futures transactions for the spot. For example, institutional and retail customers actively trade foreign currencies in spot foreign exchange (FX) markets.
Spot FX dealers may quote both a bid (to buy) and an offer (to sell) a specific currency pairing, e.g., Euros (EUR) vs. U.S. dollars (USD). Typically, such a dealer will quote a bid to buy which is somewhat less than the offer to sell and hope to profit by buying at (low) bids, selling at (relatively higher) offers and maintaining a balanced book with little or no net risk exposure. The difference or width of the bid-offer spread may represent profit to the dealer.
A spot FX dealer may price bids and offers by reference to futures prices adjusted by “forward points.” Forward points, sometimes referred to as “cost of carry,” generally reflect the difference between interest rates prevailing in the two currencies represented in the currency pairing, e.g., the difference between U.S. short-term interest rates and Euro denominated short-term interest rates. Forward points are based on the theory that buying currency A (e.g., EUR) with currency B (e.g., USD) provides the opportunity to invest currency A at prevailing currency A rates but foregoes the opportunity to invest currency B at prevailing currency B rates. Thus, the future or forward value of a currency pairing is generally dictated by the difference between prevailing interest rates in the two countries or regions whose currencies are represented in the pairing.
Sometimes, a customer submitting orders for futures contracts and/or futures contract options may be a dealer in the spot market for the underlying subject matter of such futures contracts or options. For example, an FX dealer that buys and sells a particular foreign currency may wish to trade in futures contracts and/or futures contract options concerning that foreign currency. A spot dealer may deal in such futures contracts and/or futures contracts as a way to hedge or lay-off risk associated with any unbalanced currency positions in spot market holdings. For example, an FX dealer in the spot market may have a net long EUR/USD position as a result of a transaction with a customer, or a series of transactions with multiple customers. To hedge the risk of being long in EUR (i.e., the risk associated with holding EUR instead of USD), the dealer may in turn go short (i.e., sell) in EUR/USD futures. Because the short futures position provides the dealer with a mechanism to obtain a known USD value for a known quantity of EUR on a future date (i.e., the maturity date of the sold futures contract), the dealer's long spot position is economically offset or balanced with an opposite short futures position.